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The Myth of the Absolute-Return Investor M Financial Analysts Journal Volume 62 • Number 2 ©2006, CFA Institute PERSPECTIVES The Myth of the Absolute-Return Investor M. Barton Waring and Laurence B. Siegel n meetings with clients and colleagues in the both sensible and true to the sense of the term past few years, we have noticed that many eluded us. That experience further piqued our otherwise hardheaded and clear-eyed inves- interest in the idea. I tors are excited about “absolute return” So, let us explore the term a bit. It is widely investing. The notion is spreading like wildfire. used, and because words are chosen to a purpose, Many institutional investors have already added, one can find some of that purpose by observing the or are planning to add, an absolute-return “asset context in which a term is used. class” to their policy mix. At a time when pension One important bit of context is that the word funds, foundations, and endowments are under pair “absolute return” has been used most by those pressure to increase their investment returns, abso- managers who resist the practical and theoretical lute-return investing is often positioned as The successes of relative-return investing and who are Answer—with enthusiasts arguing that it will do a looking for terminology that supports their rebel- better job of meeting institutional return require- lious spirit. The term captures this spirit: If ments than other types of investing. benchmark-relative investing is considered inade- The concept seems to have struck a special quate or wimpy by these rebels, then absolute- chord with those who have struggled to fully accept return investing implies that managers can take the the perceived confines of benchmark-relative opposite approach, one that is not benchmark rel- investing. If you have never really understood why ative. (Real men do not use benchmarks!) all investing is, in the end, relative-return investing, What does it mean to be opposite in spirit to then the notion that absolute returns might be supe- relative-return investing? We surveyed websites to rior seems to make good sense. see how investments that are purportedly absolute- Alas, we fear we have disclosed our conclusion return investments are portrayed. Not surpris- in the title, and we have more than a mild suspicion ingly, many of the descriptions are cagey; the web- that our bias shows in this introduction. So what is sites simply use the term without precisely defining absolute-return investing? What is wrong with it; what they mean by it. But some sites are less from where does our skepticism spring? Is there guarded, particularly those outside the United something valuable and redeemable in the concept, States. Here are some samples. and if so, what is it? The first is taken from a well-known financial pundit writing for SmartMoney.com:1 Why Absolute-Return Investing Is But when the bubble burst, and indeed up until this year, simply staying above water has a Myth been perceived as commendable. In fact, The first question is: Just what are “absolute” plenty of managers have boasted of their good returns? We originally assumed we could start this “relative” performance, having lost only sin- gle digits, for example, at a time in which the essay by simply reporting an agreed definition of S&P 500 index was down significantly more. the term “absolute-return investing.” Instead, we Of course, I don’t know many groceries that found ourselves repeatedly offering up ideas to can be bought using good “relative” perfor- each other for what the definition would have to be mance, if that performance . happens to be for the term to make sense. Definitions that were negative. I don’t have a degree in economics, only a stack of bills to be paid. So I start, perhaps naively so, with the basic notion that a M. Barton Waring is managing director and head of the good year is one in which I make money—end Client Advisory Group at Barclays Global Investors, of story. My benchmark might be low, but it’s San Francisco. Laurence B. Siegel is director of research very strict. A good return is a positive return, in the Investment Division of The Ford Foundation, even at a relatively low level. In hedge-fund New York City. speak, it’s what we call absolute return. 14 www.cfapubs.org ©2006, CFA Institute The Myth of the Absolute-Return Investor Here is another, from Macquarie Bank, that Definition and Importance of 2 emphasizes higher-than-market, positive returns: Relative Returns Absolute return investments can offer you potential benefits such as: If absolute returns are supposed to be different from—and better than—relative returns, perhaps a •the potential for higher returns than tradi- place to start is with a discussion of relative returns. tional asset classes Beginning in 1963, Sharpe laid the foundation for •the potential to achieve positive returns when how investment professionals understand and traditional share markets are falling— 5 because they often adopt hedging strategies. decompose total returns on portfolios today. His And another, to the same point, from the Aus- work showed how the total return on any portfolio— tralian Stock Exchange:3 note the emphasis—can be decomposed into a part that is ascribable to the return on the market bench- Absolute return funds have the ability to mark, which he called “beta,” and an idiosyncratic— produce positive investment returns regard- in this case, manager-specific—part that is uncorre- less of general market conditions. The strate- lated with the market, which he called “alpha” (plus gies they adopt can produce returns in both 6 rising and falling markets. the risk-free rate, or cash, of course). In the slightly condensed form popularized by These quotations are consistent with the notion Grinold and Kahn (2000a), this relationship is of providing a return pattern that is different in expressed as spirit from those of relative-return investments. If a definition could be teased out of these statements, rp = βprbm + αp. it might be that absolute returns are positive (as in To restate the equation in plain English, the excess absolute value) and always (or at least mostly) bet- return of a manager’s portfolio (excess over the ter than the market. The idea appears to be that, as riskless rate), rp, is the expected beta of that portfo- a result of these combined attributes, the total return lio, βp, multiplied by the excess return of the man- from absolute-return investing will have less down- ager’s normal portfolio or custom benchmark, rbm side risk and more upside return than the total (that is, the risk premium), plus an alpha (or resid- return produced in a relative-return environment. ual term), αp, that is uncorrelated with the beta Many readers of this article will have already return. rejected this expansive approach to defining abso- Sharpe’s observation is perhaps the most pro- lute returns and will have worked to come up with found insight in modern finance. The return on any, their own more sensible and less rebellious defini- repeat any, portfolio consists of a market part and tion. We will offer our own view later—a view that a nonmarket part. In the jargon of finance, this idea will give some comfort to many of those sensible is often abbreviated to simply: A portfolio has a readers. But our view is stronger: We do not sup- part that is beta and a part that is alpha. port continued use of the term. The beta part results from the average future Of course, we would not disagree that a return exposure to total market returns, often expressed in pattern that beats the market in rising markets and terms of one or more market benchmarks. This mix that does not lose money in falling markets would of exposures is sometimes called a “normal portfo- 4 be a good thing—if it really existed ex ante. (And lio.” Most long-only managers know with relative as you will see, something like it can exist—but it clarity what their normal portfolios are; simple, is not an absolute return.) single-factor examples are large-cap value and One more bit of context: Today, the term “abso- fixed-income credit. (Other, more complex exam- lute return” seems to be used most often to describe ples are also possible.) For a purported absolute- what wealthy individual investors have always return manager, the normal portfolio may not have called hedge funds. Perhaps the term is thought to been purposefully or thoughtfully designed—and give more legitimacy or sophistication to the hedge may be more implicit than explicit—but some- fund approach in the institutional context. But where in the manager’s investment style lies a absolute-return investing is really a more general “home,” a set of factor exposures or betas that the term, and it has been applied to alternative strate- manager goes to when he or she has no reason to gies other than hedge funds as well as to certain go somewhere else. conventional long-only managers (particularly Therefore, the notion that every return has a those with concentrated portfolios that bear little beta component and an alpha component applies resemblance to their benchmarks). Here, we focus to any portfolio—that is, to a portfolio with any on hedge funds because that is where the interest normal portfolio or benchmark, including complex is today. multifactor benchmarks. A portfolio that normally March/April 2006 www.cfapubs.org 15 Financial Analysts Journal contains multiple asset classes (or a fixed-income absolute-return investors: Is the expected return portfolio) could thus be analyzed within the same you offer investors attributable to
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